How To Survive The Trading Game

In the complex world of trading systems, there are two types of people: programmers and traders. Designing a trading system is a challenge, requiring complex programming experience and skill. But designing a system that actually makes money requires an excellent understanding of the markets, technicalindicators, investor sentiment and a whole array of complex data interrelationships.

So where does the programmer without trading experience get instructions? From a trader, but the success of the system depends on how well the trader can communicate to the programmer what the system should do, and then on how skilled the programmer is at translating the desired actions into programming code.

The programmer/trader hybrid is a breed apart. This is someone who, having traded with real money, knows what is needed to develop a winning trading system and also has the programming skills to put the strategy into code. Such a person suffers no misunderstandings or translation challenges. Robert James Deadman, president of Trading Systems Analysis Group (TSAGroup), is such an individual.

As a trader who designs systems, Deadman, who has 12 years of trading experience, takes a different approach to trading than most who play the markets. Not only does he have to create strategies that work in the trading arena, but he must also be able to translate them into program code so that his clients can trade them. This means he must test his strategies exhaustively to ensure they work.

Trader's AdviceWhat is the most important criterion in a trading system, according to Deadman?

"Most traders consider profitability to be top priority; but to professional traders and money managers, capital preservation or limiting losses is penultimate," he says.

Candidates must exhibit a number of conditions before they are considered.

Deadman continues, "In finding robust systems, we use a parameter called trade efficiency. How does the system perform when it is in the market against a buy and hold strategy? For this we need trading systems that outperform the buy and hold strategy. Then we look for trades that preserve capital. What is the trade's stop-loss? Lastly, we look at profitability."

"The major difference between the professional and non-professional is that the latter is looking to hit the home run while ignoring the cumulative effects of losses. What good is having a system that makes 50% but then loses 15 to 20% per trade in the next five trades? If the pro did this he or she would be out of business in short order," says Deadman.

Trading ExamplesHere is an example of what he means. When TSA's latest product, called Trade Oracle™, was used to scan a group of stocks, Zix Corporation (ZIXI), a secure e-mailing message service, came up in the search. It showed an impressive four-year return of 900% in a total of 26 trades, 21 of which were winners, a historical success rate of more than 80% and a risk/reward, measured by maximum wins to losses, of 102 to 19 or more than 5:1. It certainly had all the markings of a winner.

But this was not a trade that Deadman would consider and the reason is simple: An examination of the trading history (see figure 2) showed a projected stop-loss of 63%.

"Even though the system has made a ton of money hypothetically in the past, I am not going to consider a trade in which the stop-loss or risk represents 10%, let alone 63%," he says. "Two bad trades, my money is gone and it's back to square one."

What sort of trades does Deadman like? Here is a trade he actually took around the same time. Medco Health (MHS) came up in a scan of more than 7,000 stocks that he performs daily using end-of-day data and then scanning for candidates using Trade Oracle. The system that found the stock was the 10-day breakout. The historical success rate was 58% with a total of 34 trades, 14 of which were losers and a risk/reward of 7.4 to 2.7 or slightly less than 3:1. This looked anemic compared to ZIXI, but Deadman's most important parameter was met: the maximum stop-loss was just 1.6%.

Emotional Rescue"I use Reuters end-of-day and I want a system that I don't have to watch all the time while I'm in a trade, since I'm not a day trader. If I lose 1.6%, it's no big deal; I exit the following day and then look for my next trade," Deadman says.

"The biggest problem facing most traders is their emotions. Once I know my maximum downside, I can forget about it and just follow the signals. I'm not tempted to watch every dip and jump intraday, since that only causes unnecessary stress. The odds are in my favor and if it goes against me, my money is protected and I will still have money to trade another day."

For Deadman, it's a strategy that takes all the "unnecessary emotion" out of the equation.

Figure 3 – Daily chart of MHS showing equity curve in percent in the upper window and buy, sell and exit signals in main window. Chart provided by Metastock and trading system signals by Trade OracleTM.

"Don't get me wrong, I like to cash in on the big winners as much as anyone else," says Deadman. "But unlike most retail traders, profitability is not first but third on my list of priorities. What good is a home run if by the time it comes along I'm not in the game? By choosing trades that preserve capital, if a big win comes along it's a bonus, not essential to making money in the markets."

Stay Alive by Preserving Capital Deadman says that designing systems has forced him not only to be more disciplined in his own trading, but also to incorporate his money management philosophies into his programs. If his systems work for him in trading real money in the markets, he knows they will work for his clients.

However, he stresses that it is important to find a system that suits each individual's risk tolerance and personality. Any good system should have the flexibility to work regardless of the trader's goals, and it is important to not lose sight of your priorities.

If preservation of capital is not the most important consideration in your system, chances are you will end up a casualty of a high-stakes market roller coaster.